Thursday, October 02, 2008

Inflate, Deflate or Default

He starts off describing how some fifteen years ago he came to the well-studied, theoretically grounded conclusion:

I came to the simplistic conclusion that we, as a country, had but
three choices for righting our hopelessly listing fiscal super-tanker;
Inflate, Deflate or Default.

However, that didn't happen. Instead something very different occurred. Now he reasons that we're finally back to a fundamental point where his original thesis is valid.

Read for yourself, and read the comments (one of which you'll recognize), and let me know what you think. In my opinion, Craig cleanly summarizes the conversations, arguments and reasoning many of us have been having over the past many years on macro subjects. I'm just no[t] so sure he will be any more right this time around.

15 Comments

Randy:

I agree with your comment in that there is no way to calculate for the incalculabe; I believe Nassim Taleb has made this point well. I could go on forever and the essay has its limitations. Finally, I never seem to make a good trade based on macroeconomics.

Thanks for taking the time to visit. I've been equally unable to find repeatable macro trades. My best successes so far fall in the category of avoiding large losses without paying disproportionate opportunity costs.

Randy, your last comment on the SA thread (re: Japan and asset valuation) is ringing in my ears. I thought the exact same thing when I read both the Bailout Bill and the SEC announcement.

The way Japan really got neck deep into sh-- was by allowing the banks to hold their bad assets indefinitely without recognizing the loss. Basically they just started accumulating area under the curve into one titanic energy release. But that dragged on for years; everyone knew the banks were dead men walking, but how could anybody break the cycle?

Mark-to-model is a dangerous fantasy. Now obviously Paulson's intention is that our banks can avoid the immediate loss recognition which could trigger another death spiral. Then the banks have time to grab for the Treasury deal of taking crappy assets off the books via a reverse auction or other means.

However, it is ludicrous to think that banks will be able to get external recapitalization if they can suspend mark-to-market on complex assets and liabilities. What sovereign wealth fund would hand over billions of dollars to a bank that is deliberately shielding toxic assets? You have no idea what Paulson is going to give them, or even if they can indeed foist off all those cow paddies to the Treasury (and not just most or a few).

Since we can't repeat Japan verbatim, what would the scenario look like if we rhyme?

But it does seem to leave out the high probability of eventual new invovation.

Also the possiblity that governmental strutures that are over 200 years old are often overdue for an overhaul or replacement.

I thought the comment about trying to predict ecconomic outcomes with mathematical models without sufficient data nor sufficient processing , interesting and humorous. It is like playing chess on 100 boards simultaniously. Even if you could predict the "best" move an opponent might take, there is no reason to assume the opponent sees the best move, nor that he will take that move. Thus you must calculate based on falacy moves as well.

And when you get politicians stepping in to muddy the waters? All you can say is the rules have been changed; but it may not substantually affect the trend lines.

Even if one knows for certain that Biotechnology will do extremely well in the next 10 years, how can you possibly chose the correct investment? It usually is not the better technology that succeeds, often it is the "first to market", but even more, it is the ones with the better advertisement outreach.

I know of nothing that can pre-forecast potential advertisment advantages. And of course the one that runs out of cash first loses.

The way you'd bet on a sector you strongly believed was destined to rise over the term would be to employ a traditional (gasp, dare I say it?) _hedging_ model. To oversimplify, you'd choose the best and worst relative performer from the biotech sector, per your example. You'd short the weak and long the stronger. That mathematically ensures you benefit as the sector rises, but are protected from it falling, with a bias towards it rising. Of course, there are about ten million derivations of this strategy, and it always involves more than a single pair-trade (unless you're a hack hedge fund bozo circa 2005), but you get the idea.

There are also strategies to ensure against failure, etc. The problem with *now* is that none of those strategies are working because they keep changing the rules ad-hoc. The only effective hedge against the rule-makers changing the rules mid-stream is to take your pieces off the board. That's what is happening today. Everyone is flooding into assets where the rules are viewed as immutable: ie. US Treasuries (and some other foreign issues).

I'm planning to write up a more comprehensive article about the potentially eminent American Lost Decade (as in Japan's Lost Decade). I've written a lot about those notions in bits and pieces, and I'd like to bring it together.

I agree with you. This is what "hedge funds" are supposed to have been doing all along. They don't, most of their managers don't even know how, and, for these reasons and others, I don't think they should even be called hedge funds any longer. The hedge fund universe, as large as it has become, is providing its investors with a return that is some function of beta dependent on the leverage factor employed. These managers are supposed to provide an alpha return.

Leverage has become the crutch of the untalented manager and trader. This system wide deleveraging will take care of that. You put a thousand managers in a room and you can bet that only a handful of them will be superior. The same goes for any profession.

I'm for this bailout and I'm still disgusted by this. The Democrats have been played for fools again, they've signed on to an extremely unpopular bill to bailout Republican excesses, and they didn't even manage to get bipartisan cover of a Republican majority. Have the last 8 or 40 years taught them nothing?

This country is f_cked. It may take one election cycle or five to deliver that final blow, but I'm extremely pessismistic about the (complete lack of) quality of the political leadership.

I've just been reading some great articles on British follies (as in, the monument or faux grandeur kind). Really quite fascinating.

astrid, if we're really hosed, then the tin foil hat guys were right. The reason your comment made me think of follies was because I wonder what kind of modern-day fortress would be required to resist citizens determined to overrun your farm or steal your gold. Even ordinary citizens now have access to serious firepower like 50 caliber rifles and explosives. Could even a solid stone structure with battlements survive that?

It is impossible to see us being hosed without starting a world war, btw. The U.S. is still the breadbasket of the world, and we've still got tremendous timber, freshwater, oceanic, mining, industrial, technological and military resources at our disposal. People would accept inflating away all their savings before they swarmed into the streets. Certainly nobody is going to starve or freeze here.

Brand: A bunch of guys with guns, a weakened central government, high wealth disparity, and economic decline are not a good recipe for civil society. I'm not saying that the US would ever end up like Sudan or Haiti, but that doesn't mean it won't be pretty, particularly for complacent Americans who still think the world owes them McMansions and unqualified thumbs up.

I just read the blog on the bailout bill. Sounds like they're upset at the technical changes to the reserve banking system.

I'm not nearly as troubled as the author or the commenters at that blog. The Fed could effectively make the same changes without any Executive approval or Legislative sponsor. Coming from Congress through the Treasury is just a way of signaling to the markets that the entire government is on the same page.

Net net, the same thing was done during the Great Depression. The problem is one of creeping deflation.

I'm pretty much on the whole deflation boat now. What I found odd while reading the article was that this was supposed to become law in 2011. This correspondes to the the peak, or shortly there after, of the alt-a loan resets. I was wondering if this move was supposed to "fix" the economy in 2011 but things got so bad now they pulled the trigger. This raises the questions, was this forseen? Was it planned?

IDK, maybe its a little to conspirory theory. I did watch the Zeitgeist movies over the weekend.